What happens to interest rates when it increases and decreases?

February 4th, 2010 | by James |
Anonymous


hi, i would like to know what happens to interest rates when they increase and decrease, and what effect is this likely to have?
thanks
xx

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  1. One Response to “What happens to interest rates when it increases and decreases?”

  2. By Severe Acne Treatment System on Feb 7, 2010 | Reply

    Making Friends

    When you say the ‘interest rates’ increase or decrease, I assume that you are referring to the actions of the Federal Reserve (Fed) when they raise or lower the target rates.

    What happens is that the Fed lowers the interest rate that it charges when it lends money to other banks. This basically makes it ‘cheaper’ for the bank to borrow money from the Fed, and therefore the bank is able to lower the rate that that it charges when it makes a loan to a consumer (mortgage, car loan, etc.) since most loans that a bank makes is based on this rate plus a rate (called a ’spread’) that they add on to make a profit.

    For instance, suppose the rate that the Fed charges to loan money to other banks is 4%. Bank A will often base the rate they charge you for your car loan on this. They may charge you 5.5% (4% prime + 1.5% spread). Now suppose the Fed lowers this target rate to 3%. Now the bank may make this loan for only 4.5% (3% prime + 1.5% spread).

    Essentially this has the effect of ‘freeing’ up the credit market by making loans more affordable (and therefore more desirable) to the end consumers.

    If the Fed were to raise the rates, the opposite would be true. Generally speaking, the cost of borrowing money becomes more expensive, so less loans are made. The Fed frequently does this to combat inflation.

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